Short Sales in Financials Dry Up After US Rule

Short positions have dropped further in shares of the 19 financial firms targeted by U.S. regulators' emergency short-selling rule this week, a market data company said on Friday.

Short sales, or bets a stock will fall, are now down 98 percent in shares of mortgage finance companies Fannie Mae and Freddie Mac and have fallen 85 percent for all 19 financial companies, S3 Matching Technologies said, citing data from its clients.

S3's clients are primarily individual investors. Data on short sales by hedge funds, which have been active in this type of trading, is closely guarded by the firms.

S3 said it compared short sale data from July 14, prior to the U.S. Securities and Exchange Commission emergency rule, to the close of trade on Thursday.

The SEC's rule is part of an effort to clamp down on market manipulation that some blame for the sharp declines in financial stocks and the demise of investment bank Bear Stearns in March.

Investors who sell securities "short" borrow shares and then sell them, waiting for the stock the fall so they can buy the shares back at a lower price, return them to the lender and pocket the difference.

The rule is designed to prevent illegal "naked" short selling, which occurs when an investor sells a stock that they have not yet been borrowed.

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While the SEC said last week that its rule was not intended to stop legitimate short selling, which can prevent stocks from becoming overvalued, S3's data showed that its clients are dramatically changing their strategies.

"There has been no additional shorting from the flow that we have access to at all. It's dried up significantly, even from Monday," said John Standerfer, S3's vice president of financial services.

Since Monday -- the first day the rule took effect -- Fannie Mae and Freddie Mac short sales are down 83 percent, while for all 19 financial companies covered they are down 57 percent.

"Retail traders were shorting Fannie and Freddie a lot and now it has become virtually impossible as there are no shares available to borrow against the shorts," Standerfer said.

"Retail brokers are very concerned about complying with the SEC rule. As an intraday retail trader you used to be able to short during the day and cover near the end of the day with abandonment."

The rule requires brokers and dealers to borrow stock before executing a short sale in the 19 firms and requires investors to deliver securities on the settlement date.

"You used to be all closed out before you had to show where the shares are. Now they have to show that they have the shares up front before you can even place the order," Standerfer said.

Standerfer said the change in short-selling practices depended on the type of investor. S3's data does not include hedge funds.

Short sellers at hedge funds said this week that while the rule was making it slightly more expensive to short, as there was more demand to borrow shares, this did not provide a significant disincentive.